Auditor Could Face Liability in Lehman Case

Lehman Brothers may have collapsed a year and a half ago, but fallout from its demise has created a potential legal liability for its former accounting firm, Ernst & Young.

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Lehman Brothers

A 2,200-page report by a court-appointed examiner, Anton R. Valukas, on Lehman’s collapse has plenty of criticism for various players involved with the investment bank. But some of his harshest words are reserved for Ernst & Young and the accounting maneuvers it permitted.

Mr. Valukas writes that he found enough evidence to support at least three claims against the accounting firm for not looking more closely into Lehman’s use of questionable accounting. Lehman used the tactics, known inside the bank as Repo 105, to hide as much as $50 billion off its balance sheet to temporarily reduce its debt levels.

His report concludes that sufficient evidence exists to bring claims of malpractice against the accounting firm on the grounds of failing to disclose or investigate the technique. Legal and accounting experts say that Ernst & Young could now face potentially damaging civil litigation by private plaintiffs or the Securities and Exchange Commission — or even criminal charges by the Justice Department.

The examiner’s report has again led financial experts to question how accounting firms can fail to closely scrutinize their clients’ bookkeeping. Ernst & Young’s actions came after the passage of laws like the Sarbanes-Oxley Act of 2002 in the wake of the Enron and WorldCom accounting scandals and the collapse of Arthur Andersen for its role in those frauds.

Ernst & Young itself paid an $8.5 million fine to the S.E.C. in December for its role in allowing another client, Bally Total Fitness, to avoid restating its earnings in 2002 when accounting rules changed.

Charlie Perkins, an Ernst & Young spokesman, said in a statement that the firm’s last full audit of Lehman was for the 2007 fiscal year and that it stood by its results. “After an exhaustive investigation the examiner made no findings in his report that Lehman’s assets or liabilities were improperly valued or accounted for incorrectly in Lehman’s November 30, 2007 financial statements,” he said.

“One thing Sarbanes-Oxley reminded us of is that technical compliance isn’t enough,” said Lawrence A. Cunningham, a law professor at George Washington University. “Accounting firms need to be sitting back the whole time and thinking, is this a fair presentation?”

He added that any large judgment against the accounting firm, let alone tough regulatory action, could prove enormously damaging in terms of both money and future business.

“If a breach of liability is established here, this could be disastrous in my view,” he said.

According to the report, Ernst first learned of Lehman’s use of Repo 105 in 2001, shortly after it was designed. Partners of the accounting firm told Mr. Valukas that at the time, Ernst had not signed off on Repo 105 on anything more than a “theoretical” level, and gave approval only of Lehman’s internal policy regarding the practice.

At no point did Ernst review the approval letters by the British law firm Linklaters, the only outside legal counsel Lehman could find that would sign off on the practice.

By 2007, Mr. Valukas writes, Ernst was aware of $29 billion in Repo 105 transactions. While Ernst knew of the practice for years, the issue of Repo 105 was thrust to the fore in spring 2008. On June 12, two Ernst partners, William Schlich and Hillary Hansen, met with Matthew Lee, a Lehman executive who had written senior management a letter to complain of what he saw as accounting improprieties.

The firm was “also dealing with a whistle-blower letter, that is on its face pretty ugly and will take us a significant amount of time to get through,” Mr. Schlich wrote in a June 5 e-mail message to colleagues, the examiner’s report said.

At that meeting, Mr. Lee informed the two accountants that Lehman was using Repo 105 to move $50 billion of the firm’s assets off its balance sheet at the quarter’s end to make its debt levels look smaller. The firm reassumed those assets about a week later.

But the next day, Ernst spoke to Lehman’s audit committee — but did not disclose Mr. Lee’s allegations on Repo 105.

Mr. Perkins said Ernst never concluded its review of Mr. Lee’s claims because Lehman filed for bankruptcy before the firm could finish its audit.